As the old saying goes, cash is king. One way for companies to hold onto more cash is to qualify as a Base Rate Entity (“BRE”) which reduces the company’s tax rate from 30% down to 25%.
On the face of it this appears to be a great concession for smaller companies, however this is not always the case.
A company qualifies as a BRE in a particular income year if both of the following requirements are met:
- the aggregated turnover of the company for the income year is less than $50 million (from the 2019 income year onward); and
- no more than 80% of the company’s assessable income for that income year is Base Rate Entity Passive Income (BREPI).
An entity’s aggregated turnover is the sum of the entity’s annual turnover, any connected entity’s annual turnover and any affiliate’s annual turnover. An entity’s annual turnover for an income year is defined as the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business.
An important point to note in respect to the second requirement is that the test is based on “assessable income” and not taxable or net income.
What constitutes BREPI is limited by legislation and can be summarised as:
- corporate distributions (e.g. dividends) other than non-portfolio dividends;
- franking credits on corporate distributions;
- non-share dividends;
- interest income;
- royalties and rent;
- net capital gains;
- gains on qualifying securities; and
- amounts included in assessable income of a partnership or trust, to the extent that they are referable (directly or indirectly) to a category of base rate entity passive income listed above.
If an amount of assessable income does not fit the above criteria it is not BREPI, and therefore it is essential to understand the nature of the income.
By way of example, a business that leases out equipment is receiving income that is classified as royalty income for BREPI purposes. If the company sells the equipment and makes a taxable profit on the sale, that taxable profit is not BREPI as it is neither royalty income nor is it a capital gain.
Whether a company qualifies as a BRE is tested each year and can lead to a company having different tax rates if differing years. As the year progresses it can be prudent to test whether the company will be a BRE in the current year in order to plan for tax position based on the expected tax rate, which may be higher than the previous year.
Qualifying as a BRE has consequences that extend further that the company’s income tax liability.
A company’s franking rate for dividends is based on its corporate tax rate in the previous year. If the company did not exist in the previous year then the franking rate defaults to the BRE tax rate. The changes in tax rates can cause misalignment between the tax paid on the company’s profits, and the franking credits that are attached to the dividends when those profits are paid to shareholders.
Where historical tax rates were 30% but the franking rate is now 25%, it’s possible that franking credits get stuck inside the company with no retained profit available to pay them out. Conversely, where historical tax rates were 25% but the franking rate is now 30%, the company may not be able payout the retained profits as a fully franked dividend, which could be an issue for any foreign shareholders.
For those companies looking to utilise the refundable Research & Development Tax Offset, the rate of the offset is dependant on the company’s tax rate. The refundable offset rate is 18.5% plus the company’s tax rate in the year of the claim. Therefore, if the company is a BRE in the year of the claim then its refundable offset rate will be 43.5%. If the company was not a BRE its refundable offset rate will be 48.5%. Depending on the size of the R&D claim the cashflow impact could be significant.
Overall, being a BRE is seen to be a positive due to the additional cash that can be retained in the company. Particular attention needs to be paid to the current year’s assessable income as the BRE status changes year on year and lead to unintended outcomes.
If you need assistance in determining whether your clients company is a BRE for a particular year, please contact Ross Prosper